The bank offers risk-free, annual interest rates of 2%. You come across an alternative investment option costing $1,000 and offering $1,300 after 1 year. This investment has a 15% chance of failure and offering $0. Is there an arbitrage opportunity? Explain.Calculate the risk premium interest rate that will equate the alternative investmentwith the risk-free option. Why is the risk premium interest rate different from therisk-free rate?

Arbitrage opportunity arises when there exists a difference between the prices of similar item in…

Is there an arbitrage opportunity? Explain. Calculate the risk premium interest rate that will equate the alternative investment with the risk-free option. Why is the risk premium interest rate different from the risk-free rate?

Is there an arbitrage opportunity? Explain. Calculate the risk premium interest rate that will equate the alternative investment with the risk-free option. Why is the risk premium interest rate different from the risk-free rate?

Intermediate Financial Management (MindTap Course List)

13th Edition

ISBN:9781337395083

Author:Eugene F. Brigham, Phillip R. Daves

Publisher:Eugene F. Brigham, Phillip R. Daves

Chapter4: Bond Valuation

Section: Chapter Questions

Problem 10MC

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Question

The bank offers risk-free, annual interest rates of 2%. You come across an alternative investment option costing $1,000 and offering $1,300 after 1 year. This investment has a 15% chance of failure and offering $0.

Is there an arbitrage opportunity? Explain.
Calculate the risk premium interest rate that will equate the alternative investment
with the risk-free option. Why is the risk premium interest rate different from the
risk-free rate?

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